Motivating ESG activities through contracts and taxes
36 Pages Posted: 27 Jan 2022 Last revised: 10 Jul 2022
Date Written: January 24, 2022
Using a principal-agent model in which shareholders care about financial as well as environmental and social (ESG) outcomes, we show how contracts and regulation shape a firm's financial and ESG activities. An ESG measure is included in the contract if the ESG outcome is intrinsically valued by shareholders, if it is informative about profits or if it is subject to regulation. Regulation affects the optimal contract, and in turn, the equilibrium distribution over financial and ESG outcomes. We show that when financial and ESG outcomes have non-zero correlation, regulating one outcome induces changes in the other; we show that quadratic tax schemes can be used to motivate interior ESG targets such as diversity (e.g., 50\% female); and we show that tax schemes that interact ESG and financial outcomes make those outcomes more correlated in equilibrium (e.g., through ``green innovation''). These schemes are more effective when measurement is more reliable. When ESG measures are unreliable, ESG subsidies exacerbate greenwashing, and subsidizing (taxing) the financial performance of firms with ESG-aligned (-misaligned) technologies is more effective for improving ESG outcomes.
Keywords: ESG, CSR, shareholder welfare, carbon taxes, regulation, optimal contracting, executive compensation.
JEL Classification: D86, M41, Q56, Q58
Suggested Citation: Suggested Citation